July 1, 2021 | François Sicart
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These days, it seems, everyone has an opinion about everything.

Submitted to a deluge of information and opinions from traditional news media and now internet social networks, I’ve found that many people tend to simply repeat the views garnered from their favorite or most convenient source. So, most of the ideas that circulate in social venues such as dinners, cocktail parties or even conferences are just second-hand, recycled material that has undergone little or no critical analysis.

From an investment viewpoint, the paucity of thought behind the opinions propagated in that manner can cause poor or even dangerous decisions. As Howard Marks, Chairman and cofounder of Oaktree Capital Management, pointed out in his book The Most Important Thing (Columbia Business School Publishing – 2011), things are often more complicated than they appear because, when we solve one problem, we often end up unintentionally creating another one even worse. Most policy actions or reactions thus are the sources of unforeseen consequences.

Marks makes the point that most people use what he describes as first-level thinking, which is fast and easy but also simplistic and superficial. Because this simplistic level of thinking is the same for all people who practice it, everyone tends to reach the same conclusions. Unfortunately, to be better than the crowd, which should be the ultimate goal of investors, you first have to be different. Therefore, as Marks stresses, out-thinking the majority can’t come from first-level thinking and must come from a deeper and more complex second-level thinking that goes beyond the obvious consequences of what is happening now.

Daniel Kahneman, an Israeli psychologist who was awarded the 2002 Nobel Memorial Prize in Economic Sciences (!) questions the assumption of human rationality that underpins modern economic and financial theory. In his best-selling book “Thinking Fast and Slow” (Penguin -2011), he distinguishes between one mode of thinking that is fast, instinctive and emotional, and another one that is slower, more deliberate and more logical. This is not too different from Marks’ distinction between first-level and second-level thinking.

If one prefers a somewhat more intricate explanation of why superficial, instinctive opinions are faulty as they relate to financial markets, they can explore the theory of Reflexivity articulated by famed trader George Soros.

The theory of Reflexivity states that investors don’t base their decisions on reality, but rather on their perceptions of reality. The actions that result from these perceptions have an impact on reality itself, which in turn affects investors’ perceptions again and thus prices. The problem is that in the economy, and financial markets in particular, participants are part of the situation they have to deal with. According to Soros, the participants’ views influence the course of events, and the course of events influences the participants’ views. The influence is continuous and circular; that is what turns it into a feedback loop.

The only purpose of this lengthy introduction has been to stress once again our belief in the futility for investors of trying to predict the future – certainly in amplitude and timing. For our part, as investors, we prefer to remain agnostics about the future, which is why our answer to many questions is something few advisors will admit: “I don’t know”. This does not mean that we give up understanding problems: rather, our attitude long has been to prefer preparing ourselves for different possible outcomes.

Bernard Baruch was an American financier and statesman who was one of the country’s richest and most powerful men in the late 19th and early 20th centuries. He is famous for his remark that: “The main purpose of the stock market is to make fools of as many men as possible” but also for his advice that: “I made my money by selling too soon.” (Brainy Quotes), which he actually did before the Great Depression.

A current example of the uncertainty in economics is inflation. Some observers think that the ongoing policies to suppress interest rates (i.e., to make borrowing cost-free), combined with record fiscal stimulus (budget deficits) cannot fail to eventually cause significant price inflation. Others argue that, even before the COVID crisis, the world was subject to significant deflationary forces: the piling up of debt cannot fail to eventually cause a “Minsky Moment” – a reckoning that will take the form of a financial crisis and economic downturn.

Over the years, we have often seen the experts be wrong about major turns in the economy. I particularly remember that, after the newly-formed OPEC caused a quadrupling of oil prices practically overnight, in late 1973, three leading economists told the New York Society of Security Analysts that the event would change very little to their forecasts of modest inflation. The inflationary spiral that followed created an unexpected profit opportunity for investors in commodities while most of the rest of the stock market suffered one of its worst historical declines.

The scenario that intrigues me most today is one articulated by William R. White, former Head of the Monetary and Economic department of the Bank for International Settlements (BIS) at one of Mauldin Economics’ recent conferences.

In the 1980s, I used to visit the BIS, often referred to as “the central banks’ bank”, at least annually. Not only is it the regular meeting place of the world’s leading central bankers, but its research department keeps a keen eye on the risks threatening the world’s economic and financial systems.

Mr. White personally forewarned of the risks created by the debt bubble and the sub-prime lending folly prior to the Great Recession that started in 2007. He apparently now sees an inflation spike first (it seems to be happening now, not only in commodities but also in housing as well as in wages). There is no overwhelming worry at the Fed with regards to inflation right now, but a first indication that they are planning to start slowing the monetary floodgates within a year or so.

Typically, government and central banks are late in reversing policies and then they overreact, which is apparently what William White is expecting. I believe this is why he reportedly foresees a financial markets correction and an economic slowdown resulting from a first, timid monetary tightening after the first inflation spike.

I can only guess what he is precisely thinking but, especially since investors in particular seem to have forgotten what pain feels like, the pressure to relax monetary policy would then become unbearable and the Fed would reopen the monetary floodgates, finally releasing a true inflationary spiral.

Many things may intervene in the interim. For example, the consensus on currencies is now that the US dollar should decline after a long period when global investors were perceived as having no true alternative to keep their liquidities. The catch up of other major economies on vaccination and economic growth should strengthen their currencies, it is reasoned.

Some time ago the thought of diversifying my currencies intrigued me, too. I studied various possibilities and concluded that, especially in the midst of the COVID pandemic, no currency was much safer. Today, I am worried by an opposite scenario.

As US interest rates rise as a result of the Fed’s tightening, the US dollar might initially strengthen. The combination of higher interest rates and a rising dollar might prove devastating for a number of emerging economies who have borrowed internationally in dollars. This might actually be worse for many natural resource producers, whose export prices tend to decline when the dollar rises.

Several of these economies are already struggling to surmount the effects of the pandemic and one or several major debt crises might erupt at the periphery of the stronger economies just as they begin to recover. Then, the inflation scenario could be forgotten and we’d have to position ourselves for a recessionary environment.

It has seemed clear to me for a while that a combination of greed and fear of missing out (FOMO) has created a bubble-like speculative condition in the debt and equity markets, not to mention marginal and derivative instruments. But the timing of such a conclusion is very elusive and, true to our conviction that that it is better to prepare for eventualities than to try and predict the future, we have constructed portfolios accordingly. We expect some companies to benefit from an acceleration of the recovery and new inflationary pressures; others should survive thanks to their strong balance sheets while debt-heavy companies suffer; and, all the while, we are keeping enough cash reserves to take advantage of further opportunities. The spirit of Bernard Baruch survives.

François Sicart — June 30, 2021


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